Has FINRA barred you from the securities industry and imposed a big regulatory fine for securities fraud? Wish you could stiff FINRA on that fine? A pair of “brothers” from New York has done exactly that and it seems FINRA can do nothing about it. Sound far-fetched? Here’s the Second Circuit opinion holding that FINRA lacks the authority to file lawsuits to collect unpaid disciplinary fines.

Guess who we have to thank for this ruling that one expert says “neuters” FINRA? The infamous Fiero Brothers. You remember them. The duo behind 1995’s clever new investment strategy – the one that all of us now use regularly in our 401(k) accounts: the naked short sale bear raid on the micro-cap offerings of a pump-and-dump chop house.

Say what?

That’s exactly what FINRA said before imposing a permanent bar and imposing a $1 million fine in December 2000. The Fiero Brothers refused to pay the fine. So FINRA filed a lawsuit to collect. The case worked its way to the Second Circuit, which held that FINRA had no authority to use the courts to collect its fines. In a moment, we’ll take a quick look at why FINRA lacks this authority and whether it really “neuters” FINRA. But first, let’s take a stroll down memory lane with the Brothers, Fiero.

The Fiero Brothers

Fiero Brothers Inc. is a distinguished and venerable securities firm with deep roots in our nation’s financial history, just like many of Wall Street’s other famous brothers: Salomon Brothers, Lehman Brothers and Brown Brothers Harriman.

Actually it’s not. It was created in 1990. And it has only onebrother, John J. Fiero, Jr. He was also the firm’s only stockbroker. It appears he may have used the word “brothers” to create the illusion of a venerable old securities firm.

Fiero’s illusive brother?

In 1995, Fiero decided to pursue significant investment returns at the expense of Hanover Sterling & Company, a distinguished and venerable old securities firm . . . . No? Not venerable? Okay, Hanover Sterling was founded in 1984 and had nary a Hanover nor a Sterling at the helm. It went bankrupt as a result Fiero’s activities in 1995.

So un-venerable was Hanover that upon liquidation the trustee couldn’t find a brokerage firm that wanted Hanover’s customers. That is, until the venerable firm of Lew Lieberbaum & Co., Inc. stepped up and honorably agreed to take the accounts, despite being fresh off of its own $1.1 million fine for stock manipulation, but before its $1.75 million settlement in a sexual harassment and discrimination suit (the firm allegedly hired lesbian strippers for mid-afternoon office events).

So what’s with these names, Fiero Brothers and Hanover Sterling? They appear to be examples of what Michael Lewis described in his book The Money Culture in the Chapter on Eddie the Chop-House Boy:

“[P]ick any name remotely connected with permanence, and the odds are it has found its way into the yellow pages under ‘Investment Services.’ Buckingham Securities was one, now defunct. Versailles Securities is another. The list reads like a guide to European Monuments – either that or the Philadelphia Social Register. Eddie himself once started a firm called Mitchell, White, and Duveen, in which none of the employees was named either Mitchell, White or Duveen. Eddie, like all good con artists, understood the art of illusion.”

In this race to claim names associated with permanence and longevity, how long it will be before we see (perhaps in a FINRA disciplinary hearing) Neanderthal Brothers Inc., or Primordial Investments Inc., or better yet, Big-Bang Securities.

The Naked Bear Raid Thingamajig Against Hanover

Let’s get back to the story. So Fiero and some of his colleagues decided to launch a bear raid, naked style, on Hanover Sterling. Before explaining this savvy investment strategy, let me explain Hanover Sterling’s business model. Hanover Sterling was an underwriter and a so-called “chop house.” Hanover would contract with highly-speculative, cash-strapped companies to help them raise funds by selling securities to the public.

A typical underwriting chop house operates as follows. For illustration purposes, let’s use “Chop House” for the Chop House and Fly-By-Night, Inc. (“FBN”) for the cash-strapped corporation looking to raise investor funds. Chop House, as underwriter, has FBN issue stock (or other securities) and Chop House purchases all of the shares at a price agreed upon with FBN. FBN then takes the pile of cash received from Chop House and invests it in the next great business innovation of the century; or, perhaps more likely, blows it on generous salaries to its managers and on their creative business expenses.

Chop House then attempts to sell the securities—at a much higher price, of course—to its brokerage customers. Or, through boiler-room operations, which are telemarking outfits that cold-call strangers to peddle stocks (many of which historically operated from the boiler rooms in Manhattan buildings, which were inexpensive to lease as office space; well, they were relatively inexpensive, it’s still Manhattan, so the boiler rooms probably still cost more than prime office space in Cleveland).

Chop House would simultaneous release highly enthusiastic and optimistic “news” and “research” about FBN, designed to create the illusion that FBN was the next Microsoft, and not the next mini-Enron that it was. This is called “pumping.” When the pumped stock is sold to investors it is called “dumping.”

After the dumping, the illusion dissipates (along with FBN’s cash balances), and the investors are left with stock worth far less than they paid for it, if it has any worth at all. At his 1999 FINRA hearing, Fiero testified that Hanover was controlled “by a gang of outlaws” running a pump and dump scheme, an allegation not challenged by FINRA.

Brilliant as it may be, there was a serious problem with Hanover’s business model (aside, of course, from its illegality). It is this: other brokerage firms, such as the esteemed Fiero Brothers, might notice that Chop House is pumping junk stocks. That’s a serious problem because the Fiero Brothers have a nifty tool that they can use to “pop” the illusion created by Chop House, and make a handsome profit in the process.

Enter naked short sale bear raids. The name is complicated, but the concept is simple (sort of). Fiero detects the pumping by Hanover. Seeing the pump, Fiero knows it is just a matter of time before FBN’s stock price tanks hard. What can a savvyplayer do if he wants to bet that a stock price will fall? He can sell the stock short.

Ordinarily, this means that Fiero would borrow FBN stock, typically from a brokerage firm that would charge Fiero interest on the loan of securities. Fiero would then sell the borrowed securities into the open market at the prevailing, pumped-up price, and receive a large sum of money. Later, when the stock price tanks, Fiero goes back into the open market and buys the same number of FBN shares that he originally borrowed, but at the much lower prevailing prices. He then gives those shares to the broker who loaned him the shares originally to satisfy the loan. His profit is the difference between the funds he received when he sold the pumped-up borrowed securities and his cost of buying the now-depressed shares needed to satisfy the loan (minus any interest he paid to the broker on the borrowed securities).

To be profitable, Fiero had to ensure that the share prices fell hard before he had to repurchase the shares (that is, before he had to “cover”). Fiero did this in two ways. First, he arranged to have a number of his colleagues also sell the shares short. This flooded the market with shares for sale, which depressed the price under under ordinary supply and demand. Second, he allegedly spread information (or misinformation) about the stocks to discredit the stocks and scare investors. This type of strategy to drive down a stock’s price is called a “bear raid,” with the word “bear” used in the same sense as it is in “bear market.”

Fiero, however, added another trick. He didn’t bother borrowing the securities in the first place. He just sold them. This is called “naked short selling,” which is defined as selling a security short that you have not borrowed, nor made arrangements to borrow. Relieved of the hassle of actually having to find shares to borrow, this technique allows for more rapid sales of thinly-traded shares, significantly increasing the efficacy of the bear raid. Indeed, it appears that many of the stocks Fiero was selling short were essentially impossible to borrow. Not bothering to borrow the shares, or at least determine before the sale that they can be borrowed was, according to the Finra Panel that sanctioned Fiero, a violation of NASD Rule 3370(b)(2)(B) (“No member shall effect a ‘short’ sale for its own account in any security unless the member. . . makes an affirmative determination that the member can borrow the securities or otherwise provide for delivery of the securities by the settlement date.”).

Nevertheless, not everyone agrees that naked short selling should be outlawed or even discouraged. Those in favor of it often cite its efficacy in quickly taking down the price of fraudulently pumped stock. In this view, it’s a nice Darwinian solution to the pump and dump problem. Journalist and author Gary Weiss, for example, has long written that opponents of naked short selling are misguided, most recently here, and at length in his entertaining book Wall Street versus America in Chapters 16 and 17 (“The shorts gave Hanover a taste of the free market – and it was bitter as hell.”)

Fiero’s strategy to drive down the share prices of Hanover-sponsored stocks was highly successful. Hanover, which had large proprietary holdings in the stocks that were tanking, was desperate to stop the short selling. So desperate, in fact, that Hanover agreed to sell a large block of the shares to Fiero and his colleagues at a substantial discount in exchange for their commitment to stop the bear raid. Fiero and his colleagues used the shares to cover their short positions. After that, all was well.

No it wasn’t. After covering, Fiero immediately fired up his bear raid again. This time, however, Fiero and his colleagues determined that they would make more money if Hanover went out of business. That’s what happened. Hanover’s failure also brought down its clearing firm, Adler Coleman Clearing Corp. FINRA determined that this was illegal stock manipulation, banned Fiero, and fined him $1.1 million. Ever the fighter, though, Fiero went on to fight FINRA for eleven more years, refusing to pay the fine.

The Second Circuit’s Ruling – Much Ado?

The Second Circuit’s ruling is really not that important. It certainly does not “neuter” FINRA. The Second Circuit analyzed the statutes and rules that created FINRA, and gave it its authority, and determined that nowhere was it given power to enforce fines in court. This was telling because in other parts of the relevant act (the Securities Exchange Act of 1934), Congress granted express authority, for example, for the SEC to bring court actions. So we can assume Congress would have expressly granted FINRA this authority, if Congress had wanted FINRA to have such authority. It may do so in the future.

Also, the fact that FINRA lacks this authority does not mean it lacks teeth. FINRA has the authority to bar companies and individuals from the industry – including if they refuse to pay fines. So as a practical matter, blowing off a fine is something only a party that was banned from the industry, or who is willing to leave the industry, would ever consider doing. In addition, the Second Circuit is only one appeals court, albeit an important one. Conceivably Finra may decide to try again in another circuit, seeking a different result.

Further, we are only talking about FINRA fines. Those who commit securities fraud still face civil lawsuits from the defrauded investors and others, potential fines and penalties from the SEC, and potential fines and penalties from state securities regulators and attorneys general – not to mention criminal charges. There is no shortage of ways to punish and inflict costs on those committing securities fraud.

Finally, some sources suggest that FINRA rarely pursues collection of fines from those barred from the industry. The Fiero case was apparently somewhat unique in this regard. If ever it became truly necessary for FINRA to have access to the courts, then the gap in its authority could readily be remedied – perhaps by the SEC (the Court declined to comment on whether the SEC itself could fix this) or by act of congress. Allowing FINRA to file court cases to collect legally-imposed fines from individuals that have been barred from the securities industry would seem to be something that could garner sufficient bipartisan support.

Maybe if we professionally zoomed in on that photo we could get a finger print off of that photo of his illusive brother. 🙂

Here’s another tidbit on the “venerable” Hanover, from the SEC’s website:

“In May 1997, a FBI sting operation led to charges by the U.S. Attorney for the Eastern District of New York against Louis Malpeso, Jr., a reported Colombo crime family associate, for conspiring to commit securities fraud. The indictment alleged that Malpeso conspired with stock broker Joseph DiBella and Robert Cattogio, one of the heads of the Hanover Sterling brokerage firm, to inflate the price of a penny stock, First Colonial Ventures. The Business Week Article had reported that organized crime was manipulating First Colonial stock and warned legitimate market makers to steer clear of the stock. The indictment alleged that Malpeso offered an undercover FBI agent posing as a money manager a kickback of 25 percent in exchange for the agent purchasing $2.5 million of First Colonial stock. All three defendants pled guilty.”

well said mark! here is some more reading on these criminals. note the other boiler rooms they opened AFTER hanover in the indictment. all under the watchful eye of finra. fiero brothers were the police that finra failed to be.

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